governments control the price of tobacco by creating a price floor

governments control the price of tobacco by creating a price floor

Question 1: Many governments control the price of tobacco by creating a price floor. If a government decides to create a price floor for a product, the economy will have a deadweight loss. Draw a supply and demand curve and show how the price floor will create deadweight loss. In your diagram show the areas for Consumer Surplus, Producer Surplus, and Deadweight Loss.

In a free market without government intervention equilibrium is naturally attained through the interplay of demand and supply forces. At equilibrium, the sellers are willing and able to sell the equilibrium quantity at the prevailing price while buyers are also willing to buy at the equilibrium price. When the market meets the equilibrium supply is equal to demand. In rare case, the government interferes with the free market naturally interaction of demand and supply to control the economy. There are several ways in which the government undertakes the control and some of which includes price floor, taxes and price ceiling.

The government always apply price floors to control the price of agricultural products such as tobacco. Price floors work in a similar way as price ceiling with the mechanism of price control. Price floors mean that the government sets the minimum price of goods that the buyers cannot go below. In most case, price floors are put above the market price, meaning that the buyers have to buy at prices above market price. This means that price floors are beneficial to sellers and disadvantages the buyers. Tobacco is an agricultural product with few consumers, which means that the demand is always low. This means that the market price may be low that tobacco producers cannot make enough returns for production. In such a case, the government intervenes to put price floors that protect the farmers. For example, if the free market price determines by forces of demand and supply is at $40, then the government may set price floors at $50. The graph below explains how the government intervene in the tobacco market through price floors.

Before the price floors, the equilibrium point is given by the interplay of supply and demand curve. The intersection of the curves provides an equilibrium price at P* of tobacco with equilibrium quantity at Q*. Prior to the introduction of price floors, the region above the equilibrium price and above the supply curve provides consumer surplus. This means that the area of triangle ABC is equal to consumer surplus. On the other hand, the producer surplus is given by region below equilibrium price and above the supply curve. This can be calculated from triangle BCO. Introduction of the legal minimum price that buyers can offer for tobacco above the equilibrium price changes the consumer and producer surplus areas. The price floors are put at P1 that responds to Q1. From the graph, it can be noted that the quantity supplied of tobacco is at Q2. Consequently, there is an excess in the amount of tobacco provided with respect to the amount demanded by the consumers. This implies that price floors lead to a surplus in tobacco noted by Q2 minus Q1. After the introduction of price flows, consumer surplus is given by ADE while producer surplus is given triangle GFO plus that of DEFG. Deadweight loss is given by area ECF.

Question 2: Government regulations in some countries do not allow Milk price to be more than a certain price. Should we expect product shortage or product surplus in the market? Why? Draw the supply and demand graph and show this on the graph.

The government may intervene in a market to protect the exploitation of buyers by sellers, especially for the basic commodities. Milk is one of the necessities that consumers cannot do without; therefore if the price is not controlled, then the producers may charge higher prices above the market equilibrium. When the government control the price not to go beyond a certain level, the mechanism is referred to as price ceiling.

Price ceiling sets a given price limit below the market price that sellers cannot go beyond. The set price has to be below the market price to be effective since at or above the market price, there will be less or no impact. Below the market price, price ceiling results in a shortage of products.  The government may intervene by setting the price of milk below the market price since milk is a basic necessity, and if the producers are selling at higher prices exploiting customers. For example, if a packet if milk in the market goes at $5, then the government may set a minimum price at $4 to make it affordable for consumers. The graph below illustrates how to price ceiling works in a market.

From the graph, it can be noted that if the government introduces a price ceiling, then the amount of milk demanded will be more than the amount supplied in the market by producers. This means that people will lack enough milk in the market. Consequently, the price ceiling leads to a shortage of milk in the market. The government puts price ceiling to take care and consider the interest of buyers. It is therefore essential for the price controller to decide whether the consumers will not be able to buy milk, or there will be less milk in the market. Price ceilings are benefits consumers by making staples cheap in the short run. However, a binding price has long-term demerits. Some of the long-term disadvantages are an increase in shortages, low quality of products, and extra charges. Due to low pay, producers may reduce the quality of products to incur low production costs. Most economies are worried about price ceilings because it is associated with deadweight loss. If appropriately applied, consumers are able to benefit significantly. Price ceiling interferes with the normal interaction of demand and supply curves in the market.